Directions to students: Download the solution to part 1 in the doc share (FILE: Unit 1 ETHICS CASE) or by clicking on the button to the left. Review the solution to parts 1 and 2 in the case. Drawing on your own experiences and the model in the text (Exhibit 1-13) answer parts 3 and 4 using a word document You do not have to do any additional research. Look on page 28 Exhibit 1-13 is there on the attached document. CHAPTER Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 93740_01_ch01_p002-051.qxd 10/8/08 10:35 PM Page 2 1 Accounting as a Form of Communication Learning Outcomes After studying this chapter, you should be able to: LO1 LO2 LO3 LO4 LO5 Explain what business is about. Distinguish among the forms of organization. Describe the various types of business activities. Define accounting and identify the primary users of accounting information and their needs. Explain the purpose of each of the financial statements and the relationships among them and prepare a set of simple statements. S t u d y L i n k s . . . A Look at This Chapter Business is the foundation upon which accounting rests. After a brief introduction to business, we begin the study of accounting by considering what accounting is and who uses the information it provides. We will see that accounting is an important form of communication and that financial statements are the medium that accountants LO6 LO7 LO8 Identify and explain the primary assumptions made in preparing financial statements. Identify the various groups involved in setting accounting standards and the role of auditors in determining whether the standards are followed. Explain the critical role that ethics play in providing useful financial information. use to communicate with those who have some interest in the financial affairs of a company. A Look at Upcoming Chapters Chapter 1 introduces accounting and financial statements. Chapter 2 looks in more detail at the composition of the statements and the conceptual framework that supports the work of an accountant. Chapter 3 steps back from financial statements and examines how companies process economic events as a basis for preparing the statements. Chapter 4 completes the introduction to the accounting model by considering the importance of accrual accounting in this communication process. 93740_01_ch01_p002-051.qxd 10/8/08 10:35 PM Page 3 Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 Kellogg Company MAKING BUSINESS DECISIONS ick your favorite company. Maybe it is Abercrombie & Fitch because you buy all of your clothes there. Or maybe it is Google because you use its search engine nearly every day. Or is it Coca-Cola because you like its commercials? At any rate, have you ever considered how the company got started? Consider Kellogg Company. The Battle Creek, Michigan-based cereal company got its start over one hundred years ago when two brothers by sheer chance discovered toasted flakes. W. K. Kellogg and his brother, Dr. John Harvey Kellogg, were cooking wheat for a type of granola, left for a while, and came back to find that the wheat had become stale. They put the wheat through the rollers anyway, and what came out was a thin flake. From this came the formation of the Battle Creek Toasted Corn Flake Company, the forerunner of Kellogg Company. From this modest start, Kellogg Company has grown to the point that it employs 25,000 people around the globe, manufactures its products in 17 countries, and markets those products in more than 180 countries. The company's brand names are among the most recognizable in the world, including such heavyweights as Kellogg's, Keebler, Rice Krispies, and Special K. As you will see throughout your study of business, all companies must make decisions and all decisions inherently involve risks. When the Kellogg brothers made the decision to form their company in 1906, they risked some of their own money to start a business that eventually revolutionized the way people eat breakfast. Over the course of one hundred years, Kellogg Company has faced any number of other critical decisions. One of the most far-reaching of these decisions was made in 2001 when it finalized the acquisition of Keebler Foods Company. At one time in its history, cereal was Kellogg Company's only business. The company's product mix changed dramatically in 2001 when it acquired Keebler, a leading producer of cookies and crackers, for over $4 billion. How does management of a company, its stockholders, and others interested in the financial well-being of a company know if the company is making good business decisions? Was Keebler \"worth\" the $4 billion that Kellogg Company paid for it? Although questions such as these have no clear-cut answers, the numbers produced P Getty Images by an accounting system go a long way in assessing a company's financial performance. Consider the Financial Highlights shown here as they appeared in Kellogg Company's 2006 annual report. The first chart shows that sales have increased for six consecutive years, not coincidentally the length of time since the company acquired Keebler. Net sales in 2006 reached nearly $11 billion. Operating profit, a measure that gives an indication as to how well a company is controlling the costs necessary to generate sales, has also risen steadily over this period, as shown in the second chart. Of course, it isn't just companies that use financial information in making decisions. For example, when you were deciding whether to enroll at your present school, you needed information about the tuition and other costs at the different schools you were considering. When a stockbroker decides whether to recommend to a client the purchase of stock in a company, the broker needs information about the company's profits and needs to know whether it pays dividends. When trying to decide whether to loan money to a company, a banker must consider the company's current debts. This book explores how accounting can help everyone make informed decisions. Before turning to the role of (continued ) 3 93740_01_ch01_p002-051.qxd Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 4 10/8/08 Chapter 1 10:35 PM Page 4 Accounting as a Form of Communication accounting in decision making, we need to explore business in more detail. Then we turn to the measures that accountants use to assess a company's performance: What is revenue? How is it measured? (See pp. 16-17.) What is business? (See pp. 4-5.) How do revenue and net income relate to a company's assets? (See pp. 15-17.) What forms of organization carry on business activities? (See pp. 6-8.) In what types of business activities do those organizations engage? (See pp. 8-10.) What is net income? How is it measured? (See pp. 16-17.) Where do the various items appear on a company's financial statements? (See pp. 15-18.) Financial Highlights Net Sales (millions $) Operating Profit (millions $) 10,907 9,614 8,304 02 10,177 1,681 1,508 8,812 03 04 Net sales increased again in 2006, the sixth consecutive year of growth. 05 03 1,766 05 06 1,544 02 1,750 06 04 Operating profit increased despite cost inflation, significant investment in future growth, and the effect of expensing stock options. Source: Kellogg Company's web site and its 2006 annual report. What Is Business? LO1 Explain what business is about. Business All of the activities necessary to provide the members of an economic system with goods and services. Just as Kellogg's got its start over one hundred years ago in Battle Creek, Michigan, your study of accounting has to start somewhere. All disciplines have a foundation on which they rest. For accounting, that foundation is business. Broadly defined, business consists of all activities necessary to provide the members of an economic system with goods and services. Certain business activities focus on the providing of goods or products, such as ice cream, automobiles, and computers. Some of these companies, such as Kellogg's, produce or manufacture the products. Other companies are involved in the distribution of the goods, either as wholesalers (who sell to retail outlets) or retailers (who sell to consumers). Other business activities, by their nature, are service-oriented. Corporate giants such as Citicorp, Walt Disney, Time Warner, and United Airlines remind us of the prominence of service activities in the world today. The relatively recent phenomenon of various \"service providers,\" such as health-care organizations and Internet companies, is a testimony to the growing importance of the service sector in the U.S. economy. To appreciate the kinds of business enterprises in our economy, consider the various types of companies that have a stake in the delivery of a box of cereal to the grocery store. 93740_01_ch01_p002-051.qxd 10/8/08 10:35 PM Page 5 Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 What Is Business? First, Kellogg's must contract with various suppliers of the raw materials, such as grains that are needed to produce cereal. For example, assume that Kellogg's buys grains from Wholesome Wheat. As a manufacturer or producer, Kellogg's takes the grain and other various raw materials and transforms them into a finished product. At this stage, a distributor or wholesaler gets involved. For example, assume that Kellogg's sells cereal to Duffy's Distributors. Duffy's Distributors, in turn, sells the products to many different retailers, such as Albertson's and Safeway. Although maybe less obvious, any number of service companies are also involved in the process. For example, ABC Transport hauls the grains to Kellogg's for production, and others move the cereal along to Duffy's Distributors. Still others get the cereal to supermarkets and other retail outlets. Exhibit 1-1 summarizes the process. EXHIBIT 1-1 Types of Businesses Supplier: Wholesome Wheat Product Companies Wheat Cereal Cereal Manufacturers/ Producers: Kellogg's Service Companies Distributor/ Wholesaler: Duffy's Distributors Retailers: Albertsons' Service Companies: ABC Transport P O D R E V I E W 1.1 LO1 Explain what business is about. Business consists of all activities necessary to provide members of an economic system with goods and services. Suppliers, manufacturers, wholesalers, and retailers are examples of product companies. QUESTIONS 1 . A department store is an example of a a. b. c. d. wholesaler. manufacturer. retailer. supplier. 2 . An airline is an example of a a. b. c. d. service provider. retailer. supplier. producer. 5 93740_01_ch01_p002-051.qxd 6 10/8/08 Chapter 1 10:35 PM Page 6 Accounting as a Form of Communication Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 Forms of Organization LO2 Distinguish among the forms of organization. There are many different types of organizations in our society. One convenient way to categorize the myriad types is to distinguish between those that are organized to earn money and those that exist for some other purpose. Although the lines can become blurred, business entities such as Kellogg's generally are organized to earn a profit, whereas nonbusiness entities generally exist to serve various segments of society. Both types are summarized in Exhibit 1-2. BUSINESS ENTITIES Business entity An organization operated to earn a profit. Business entities are organized to earn a profit. Legally, a profit-oriented company is one of three types: a sole proprietorship, a partnership, or a corporation. Sole Proprietorships This form of organization is characterized by a single owner. Sole proprietorship A form of organization with a single owner. Economic entity concept The assumption that a single, identifiable unit must be accounted for in all situations. Partnership A business owned by two or more individuals; the organization form often used by accounting firms and law firms. EXHIBIT 1-2 Many small businesses are organized as sole proprietorships. Very often the business is owned and operated by the same person. Because of the close relationship between the owner and the business, the affairs of the two must be kept separate. This is one example in accounting of the economic entity concept, which requires that a single, identifiable unit of organization be accounted for in all situations. For example, assume that Bernie Berg owns a neighborhood grocery store. In paying the monthly bills, such as utilities and supplies, Bernie must separate his personal costs from the costs associated with the grocery business. In turn, financial statements prepared for the business must not intermingle Bernie's personal affairs with the company affairs. Unlike the distinction made for accounting purposes between an individual's personal and business affairs, the Internal Revenue Service (IRS) does not recognize the separate existence of a proprietorship from its owner. That is, a sole proprietorship is not a taxable entity; any profits earned by the business are taxed on the return of the individual. Partnerships A partnership is a business owned by two or more individuals. Many small businesses begin as partnerships. When two or more partners start out, they need some sort of agreement as to how much each will contribute to the business and how they will divide any profits. In many small partnerships, the agreement is often just an oral understanding between the partners. In large businesses, the partnership agreement is formalized in a written document. Although a partnership may involve just two owners, some have thousands of partners. Public accounting firms, law firms, and other types of service companies are often Forms of Organization Business Entities Sole Proprietorships Partnerships Nonbusiness Entities Corporations Federal Government and Its Agencies Government Entities State and Local Governments and Their Agencies Private Organizations Hospitals, Universities, Cooperatives, Philanthropic Organizations 93740_01_ch01_p002-051.qxd 10/8/08 10:35 PM Page 7 Forms of Organization 7 Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 organized as partnerships. Like a sole proprietorship, a partnership is not a taxable entity. The individual partners pay taxes on their proportionate shares of the profits of the business. Corporations Although sole proprietorships and partnerships dominate in sheer number, corporations control an overwhelming majority of the private resources in this country. A corporation is an entity organized under the laws of a particular state. Each of the 50 states is empowered to regulate the creation and operation of businesses organized as corporations in it. Even though Kellogg's is headquartered in Michigan, for legal reasons, it is incorporated under the laws of the state of Delaware. To start a corporation, one must file articles of incorporation with the state. If the articles are approved by the state, a corporate charter is issued, and the corporation can begin to issue stock. A share of stock is a certificate that acts as evidence of ownership in a corporation. Although not always the case, stocks of many corporations are traded on organized stock exchanges, such as the New York and American Stock Exchanges. Kellogg Company stock is traded on the New York Stock Exchange. Corporation A form of entity organized under the laws of a particular state; ownership evidenced by shares of stock. Share of stock A certificate that acts as evidence of ownership in a corporation. Advantages of Incorporation What are the advantages of running a business as a corporation? One of the primary advantages of the corporate form of organization is the ability to raise large amounts of money in a relatively brief period of time. This is what prompted Kellogg Company to eventually \"go public.\" To raise money, the company sold a specific type of security: stock. As stated earlier, a share of stock is simply a certificate that evidences ownership in a corporation. Sometimes corporations issue another type of security called a bond. A bond is similar in that it is a certificate or piece of paper issued to someone. However, it is different from a share of stock in that a bond represents a promise by the company to repay a certain amount of money at a future date. In other words, if you were to buy a bond from a company, you would be lending it money. Interest on the bond is usually paid semiannually. You will learn more about stocks and bonds later. Bond A certificate that represents a corporation's promise to repay a certain amount of money and interest in the future. The ease of transfer of ownership in a corporation is another advantage of this form of organization. If you hold shares of stock in a corporation whose stock is actively traded and you decide that you want out, you simply call your broker and put in an order to sell. Another distinct advantage is the limited liability of the stockholder. Generally speaking, a stockholder is liable only for the amount contributed to the business. That is, if a company goes out of business, the most the stockholder stands to lose is the amount invested. On the other hand, both proprietors and general partners usually can be held personally liable for the debts of the business. NONBUSINESS ENTITIES Most nonbusiness entities are organized for a purpose other than to earn a profit. They exist to serve the needs of various segments of society. For example, a hospital is organized to provide health care to its patients. A municipal government is operated for the benefit of its citizens. A local school district exists to meet the educational needs of the youth in the community. All of these entities are distinguished by the lack of an identifiable owner. The lack of an identifiable owner and of the profit motive changes to some extent the type of accounting used by nonbusiness entities. This type, called fund accounting, is discussed in advanced accounting courses. Regardless of the lack of a profit motive in nonbusiness entities, there is still a demand for the information provided by an accounting system. For example, a local government needs detailed cost breakdowns in order to levy taxes. A hospital may want to borrow money and will need financial statements to present to the prospective lender. Nonbusiness entity An organization operated for some purpose other than to earn a profit. 93740_01_ch01_p002-051.qxd 8 10/8/08 10:35 PM Chapter 1 Page 8 Accounting as a Form of Communication Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 ORGANIZATIONS AND SOCIAL RESPONSIBILITY Although nonbusiness entities are organized specifically to serve members of society, U.S. business entities also have become more sensitive to their broader social responsibilities. Because they touch the lives of so many members of society, most large corporations recognize the societal aspects of their overall mission and have established programs to meet their social responsibilities. Some companies focus their efforts on local charities, while others donate to national or international causes. All of the companies showcased in the chapter openers of this book have programs in place to meet their corporate giving objectives. P O D R E V I E W 1.2 LO2 Distinguish among the forms of organization. Some entities are organized to earn a profit while others are organized to serve various segments of society. The three forms of business entities are sole proprietorships, partnerships, and corporations. QUESTIONS 1 . Kellogg's is organized as which of the follow- 2 . One of the advantages of the corporate form ing business entities? of organization is a. b. c. d. a. the ease of transfer of ownership. b. the limited liability of the stockholder. c. the ability to raise large amounts of capital in a relatively brief period of time. d. all of the above are advantages of the corporate form of organization. sole proprietorship partnership corporation none of the above The Nature of Business Activity LO3 Describe the various types of business activities. Because corporations dominate business activity in the United States, this book will focus on this form of organization. Corporations engage in a multitude of different types of activities. It is possible to categorize all of them into one of three types, however: financing, investing, and operating. FINANCING ACTIVITIES Liability An obligation of a business. Capital stock Indicates the owners' contributions to a corporation. All businesses must start with financing. Simply put, money is needed to start a business. W. K. Kellogg needed money in 1906 to start his new company. The company found itself in need of additional financing later and thus eventually made the decision to sell stock to the public. Most companies not only sell stock to raise money but also borrow from various sources to finance their operations. Accounting has its own unique terminology. In fact, accounting is often referred to as the language of business. The discussion of financing activities brings up two important accounting terms: liabilities and capital stock. A liability is an obligation of a business; it can take many different forms. When a company borrows money at a bank, the liability is called a note payable. When a company sells bonds, the obligation is termed bonds payable. Amounts owed to the government for taxes are called taxes payable. Assume that Kellogg's buys corn to be used to produce Corn Flakes. Assume that the supplier gives Kellogg's 30 days to pay the amount owed. During this 30-day period, Kellogg's has an obligation called accounts payable. Capital stock is the term used by accountants to indicate the dollar amount of stock sold to the public. Capital stock differs from liabilities in one very important respect. 93740_01_ch01_p002-051.qxd 10/8/08 10:35 PM Page 9 Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 The Nature of Business Activity Those who buy stock in a corporation are not lending money to the business, as are those who buy bonds in the company or make a loan in some other form to the company. Someone who buys stock in a company is called a stockholder, and that person is providing a permanent form of financing to the business. In other words, there is not a due date at which time the stockholder will be repaid. Normally, the only way for a stockholder to get back his or her original investment from buying stock is to sell it to someone else. Someone who buys bonds in a company or in some other way makes a loan to it is called a creditor. A creditor does not provide a permanent form of financing to the business. That is, the creditor expects repayment of the amount loaned and, in many instances, payment of interest for the use of the money. 9 Stockholder One of the owners of a corporation. Alternate term: Shareholder. Creditor Someone to whom a company or person has a debt. Alternate term: Lender. INVESTING ACTIVITIES There is a natural progression in a business from financing activities to investing activities. That is, once funds are generated from creditors and stockholders, money is available to invest. An asset is a future economic benefit to a business. For example, cash is an asset to a company. To Kellogg's, its buildings and the equipment that it uses to make cereal are assets. At any time, Kellogg's has on hand raw materials and products in various stages of production. These materials and products are called inventories and are another valuable asset of the company. An asset represents the right to receive some sort of benefit in the future. The point is that not all assets are tangible in nature, as are inventories and buildings and equipment. For example, assume that Kellogg's sells cereal to one of its customers and allows the company to pay at the end of 30 days. At the time of the sale, Kellogg's doesn't have cash yet, but it has another valuable asset. The right to collect the amount due from the customer in 30 days is an asset called an account receivable. As a second example, assume that a company acquires from an inventor a patent that will allow the company the exclusive right to manufacture a certain product. The right to the future economic benefits from the patent is an asset. In summary, an asset is a valuable resource to the company that controls it. At this point, you should notice the inherent tie between assets and liabilities. How does a company satisfy its liabilities, that is, its obligations? Although there are some exceptions, most liabilities are settled by transferring assets. The asset most often used to settle a liability is cash. Asset A future economic benefit. OPERATING ACTIVITIES Once funds are obtained from financing activities and investments are made in productive assets, a business is ready to begin operations. Every business is organized with a purpose in mind. The purpose of some businesses is to sell a product. For example, Kellogg's was organized to produce and sell cereal. Other companies provide services. Service-oriented businesses are becoming an increasingly important sector of the U.S. economy. Some of the largest corporations in this country, such as banks and airlines, sell services rather than products. Accountants have a name for the sale of products and services. Revenue is the inflow of assets resulting from the sale of products and services. When a company makes a cash sale, the asset it receives is cash. When a sale is made on credit, the asset received is an account receivable. Revenue represents the dollar amount of sales of products and services for a specific period of time. We have thus far identified one important operating activity: the sale of products and services. However, costs must be incurred to operate a business. Kellogg's must pay its employees salaries and wages. Suppliers must be paid for purchases of inventory, and the utility company has to be paid for heat and electricity. The government must be paid the taxes owed it. All of these are examples of important operating activities of a business. Accountants use a specific name for the costs incurred in operating a business. An expense is the outflow of assets resulting from the sale of goods and services. Exhibit 1-3 summarizes the three types of activities conducted by a business. The discussion and the exhibit present a simplification of business activity; but actual businesses Revenue An inflow of assets resulting from the sale of goods and services. Expense An outflow of assets resulting from the sale of goods and services. 93740_01_ch01_p002-051.qxd 10 10/8/08 Chapter 1 Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 EXHIBIT 1-3 10:35 PM Page 10 Accounting as a Form of Communication A Model of Business Activities Financing Activities Raising money to start the business Kellogg's started with owner investments. Money raised through financing is needed for investing. Some profits are used to pay creditors while other profits are reinvested in productive assetssuch as more equipment. Operating Activities Investing Activities Generating revenues (and profits) via sales Buying assets Assets are used to generate revenues. Kellogg's sells products to its customers. Kellogg's invested in assets such as equipment to start its business. are in a constant state of motion with many different financing, investing, and operating activities going on at any one time. Still, the model as portrayed in Exhibit 1-3 should be helpful as you begin the study of accounting. To summarize, a company obtains money from various types of financing activities, uses the money raised to invest in productive assets, and then provides goods and services to its customers. POD REVIEW 1 .3 LO3 Describe the various types of business activities. All business activities can be categorized as being operating, investing, or financing activities. Financing activities involve raising money from contributions made by the owners of a business as well as obtaining loans from outsiders. Companies invest the amounts raised from financing activities in various types of assets, such as inventories, buildings, and equipment. Once funds are obtained and investments are made in productive assets, a business can begin operations. Operating activities involve providing goods and services to customers. QUESTIONS 1 . Capital stock as a form of financing differs from borrowing because a. b. c. d. stock has a due date. stock does not have a due date. borrowing is a permanent form of financing. there are no significant differences between the two forms of financing. 2 . Which of the following is not an asset? a. accounts payable b. cash c. accounts receivable d. building 3 . The inflow of assets resulting from the sale of products and services is called a(n) a. b. c. d. expense. asset. revenue. liability. 93740_01_ch01_p002-051.qxd 10/8/08 10:35 PM Page 11 Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 W hat Is Accounting and What Information Do Users of Accounting Reports Need? 11 What Is Accounting and What Information Do Users of Accounting Reports Need? Accounting is not just a procedural record-keeping activity done by people who are \"good at math.\" In fact, accounting is \"the process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by users of the information.1 Each of the three activities in this definitionidentifying, measuring, and communicatingrequires the judgment of a trained professional. Note that the definition refers to the users of economic information and the decisions they make. Who are the users of accounting information? We turn now to this important question. USERS OF ACCOUNTING INFORMATION AND THEIR NEEDS LO4 Define accounting and identify the primary users of accounting information and their needs. Accounting The process of identifying, measuring, and communicating economic information to various users. It is helpful to categorize users of accounting information on the basis of their relationship to the organization. Internal users, primarily the managers of a company, are involved in the daily affairs of the business. All other groups are external users. INTERNAL USERS The management of a company is in a position to obtain financial information in a way that best suits its needs. For example, if management of a Kellogg's production facility center needs to know whether the plant's revenues are enough to cover its operating costs, this information exists in the accounting system and can be reported. If the manager wants to find out if the monthly payroll is more or less than the budgeted amount, a report can be generated to provide the answer. Management accounting is the branch of accounting concerned with providing internal users (management) with information to facilitate planning and control. The ability to produce management accounting reports is limited only by the extent of the data available and the cost involved in generating the relevant information. Management accounting The branch of accounting concerned with providing management with information to facilitate planning and control. EXTERNAL USERS External users, those not directly involved in the operations of a business, need information that differs from that needed by internal users. In addition, the ability of external users to obtain the information is more limited. Without the day-to-day contact with the affairs of the business, outsiders must rely on the information presented to them by the management of the company. Certain external users such as the IRS require that information be presented in a very specific manner, and they have the authority of the law to ensure that they get the required information. Stockholders, bondholders, and other creditors must rely on financial statements for their information.2 Financial accounting is the branch of accounting concerned with communication with outsiders through financial statements. 1 American Accounting Association, A Statement of Basic Accounting Theory (Evanston, Ill.: American Accounting Association, 1966), p. 1. 2 Technically, stockholders are insiders because they own stock in the business. In most large corporations, however, it is not practical for stockholders to be involved in the daily affairs of the business. Thus, they are better categorized here as external users because they normally rely on general-purpose financial statements, as do creditors. Financial accounting The branch of accounting concerned with the preparation of financial statements for outsider use. 93740_01_ch01_p002-051.qxd 12 10/8/08 Chapter 1 10:35 PM Page 12 Accounting as a Form of Communication Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 Stockholders and Potential Stockholders Both existing and potential stockholders need financial information about a business. If you currently own stock in Kellogg's, you need information that will aid in your decision either to continue to hold the stock or to sell it. If you are considering buying stock, you need financial information that will help in choosing among competing alternative investments. What has been the recent performance of the company in the stock market? What were its profits for the most recent year? How do these profits compare with those of the prior year? Did the company pay any dividends? One source for much of this information is the company's financial statements. Bondholders, Bankers, and Other Creditors Before buying a bond in a company (remember you are lending money to the company), you need to feel comfortable that the company will be able to pay you the amount owed at maturity and the periodic interest payments. Financial statements can help you to decide whether to purchase a bond. Similarly, before lending money, a bank needs information that will help it determine the company's ability to repay both the amount of the loan and interest. Therefore, a set of financial statements is a key ingredient in a loan proposal. Government Agencies Numerous government agencies have information needs specified by law. For example, the IRS is empowered to collect a tax on income from both individuals and corporations. Every year a company prepares a tax return to report to the IRS the amount of income it earned. Another government agency, the Securities and Exchange Commission (SEC), was created in the aftermath of the Great Depression. This regulatory agency sets the rules under which financial statements must be prepared for corporations that sell their stock to the public on organized stock exchanges. Similar to the IRS, the SEC prescribes the manner in which financial information is presented to it. Companies operating in specialized industries submit financial reports to other regulatory agencies, such as the Interstate Commerce Commission (ICC) and the Federal Trade Commission (FTC). Other External Users Many other individuals and groups rely on financial information given to them by businesses. A supplier of raw material needs to know the creditworthiness of a company before selling it a product on credit. To promote its industry, a trade association must gather financial information on the various companies in the industry. Other important users are stockbrokers and financial analysts. They use financial reports in advising their clients on investment decisions. In reaching their decisions, all of these users rely to a large extent on accounting information provided by management. Exhibit 1-4 summarizes the various users of financial information and the types of decisions they must make. USING FINANCIAL ACCOUNTING INFORMATION As stated earlier, financial accounting is concerned with communication with external users. One of the primary external users of accounting information is a stockholder. The box on page 14 contains a Financial Decision Framework that can be used to help make investment decisions using financial accounting information. Here you'll consider whether to buy a company's stock. For example, for the last few months, you have been eagerly awaiting an earnings announcement from Kellogg's. You have bought the company's products for a few years but never gave much thought to the financial side of its business. You log on to Kellogg's web site; and after clicking on the Investor Relations link, you begin to wonder . . . should I or shouldn't I buy stock in the company? Use the Financial Decision Framework on page 14 to help you make a decision. 93740_01_ch01_p002-051.qxd 10/8/08 10:35 PM Page 13 W hat Is Accounting and What Information Do Users of Accounting Reports Need? Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 EXHIBIT 1-4 13 Users of Accounting Information Categories of Users Examples of Users Common Decision Relevant Question Internal Management Should we build another plant? How much will it cost to build the new plant? External Stockholder Should I buy shares of Kellogg's stock? How much did the company earn last year? Banker Should I lend money to Kellogg's? What debts or liabilities does the company have? Employee Should I ask for a raise? How much are the company's revenues, and how much is it paying out in salaries and wages? Is the compensation it is paying reasonable compared to its revenues? Supplier Should I allow Kellogg's to buy grain from me and pay me later? What is the current amount of the company's accounts payable? POD REVIEW 1 .4 LO4 Define accounting and identify the primary users of accounting information and their needs. The primary users of financial statements are those who depend on the economic information conveyed in those statements to make decisions. Primary users may be broadly classified as internal users and users external to the company. Internal users are usually managers of a company. External users include stockholders, investors, creditors, and government agencies. QUESTIONS 1 . Which of the following groups is not an exter- nal user of accounting information? a. b. c. d. stockholders bankers management all of the above are external users 2 . The branch of accounting that is concerned with communication with outsiders through financial statements is a. b. c. d. management accounting. financial accounting. income tax accounting. none of the above. 93740_01_ch01_p002-051.qxd 14 10/8/08 Chapter 1 10:35 PM Page 14 Accounting as a Form of Communication Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 FINANCIAL DECISION FRAMEWORK Use the following decision process to help you make an investment decision about Kellogg's or any other public company. 1. Formulate the Question For about the same amount I pay in a year for the company's products ($100) I could buy 2 shares of Kellogg's stock at $50 per share. Should I invest $100 in Kellogg's? 2. Gather Information from the Financial Statements and Other Sources The information needed will come from a variety of sources: My personal finances at the present time Alternative uses for the $100 The outlook for the industry Publicly available information about Kellogg's, including its financial statements 3. Analyze the Financials The information in the financial statements can be used to perform: Ratio analysis (looking at relationships among financial statement items). Horizontal analysis (looking at trends over time). Vertical analysis (comparing financial statement items in a single period). Comparisons with competitors. Comparisons with industry averages. 4. Make the Decision Taking into account all of the various sources of information, you decide either to: Use the $100 for something else. Invest the $100 in Kellogg's. 5. Interpret the Results If you do decide to invest, you will want to monitor your investment periodically. Whether you made a good decision will be based on the answers to these two questions: Have I received any dividends on my shares? Has the price of the stock increased above the $50 per share that I paid? A critical step in this framework is gathering information from the financial statements, the means by which an accountant communicates information about a company to those interested in it. We explore these statements in the next section. Financial Statements: How Accountants Communicate LO5 Explain the purpose of each of the financial statements and the relationships among them and prepare a set of simple statements. The primary focus of this book is financial accounting. This branch of accounting is concerned with informing management and outsiders about a company through financial statements. We turn now to the composition of the four major statements: the balance sheet, the income statement, the statement of retained earnings, and the statement of cash flows. THE ACCOUNTING EQUATION The accounting equation is the foundation for the entire accounting system: Assets Liabilities Owners' Equity The left side of the accounting equation refers to the assets of the company. Those items that are valuable economic resources and that will provide future benefit to the company should appear on the left side of the equation. 93740_01_ch01_p002-051.qxd 10/8/08 10:35 PM Page 15 Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 Financial Statements: How Accountants Communicate The right side of the equation indicates who provided, or has a claim to, those assets. Some of the assets were provided by creditors, and they have a claim to them. For example, if a company has a delivery truck, the dealer that provided the truck to the company has a claim to the assets until the dealer is paid. The delivery truck would appear on the left side of the equation as an asset to the company; the company's liability to the dealer would appear on the right side of the equation. Other assets are provided by the owners of the business. Their claims to these assets are represented by the portion of the right side of the equation called owners' equity. The term stockholders' equity is used to refer to the owners' equity of a corporation. Stockholders' equity is the mathematical difference between a corporation's assets and its obligations or liabilities. That is, after the amounts owed to bondholders, banks, suppliers, and other creditors are subtracted from the assets, the amount remaining is the stockholders' equity, the amount of interest or claim that the owners have on the assets of the business. Stockholders' equity arises in two distinct ways. First, it is created when a company issues stock to an investor. As noted earlier, capital stock reflects ownership in a corporation in the form of a certificate. It represents the amounts contributed by the owners to the company. Second, as owners of shares in a corporation, stockholders have a claim on the assets of a business when it is profitable. Retained earnings represents the owners' claims to the company's assets that result from its earnings that have not been paid out in dividends. It is the earnings accumulated or retained by the company. THE BALANCE SHEET The balance sheet (sometimes called the statement of financial position) is the financial statement that summarizes the assets, liabilities, and owners' equity of a company. It is a snapshot of the business at a certain date. A balance sheet can be prepared on any day of the year, although it is most commonly prepared on the last day of a month, quarter, or year. At any point in time, the balance sheet must be \"in balance.\" That is, assets must equal liabilities and owners' equity. For a company such as Kellogg's, real financial statements can be quite complex, especially this early in your study of accounting. Therefore, before we attempt to read Kellogg's statements, we will start with a hypothetical company. Top of the World owns and operates a ski resort in the Rockies. The company's balance sheet on June 30, 2008, the end of its first year of business, is presented in Exhibit 1-5. As you study the exhibit, note the description for each item to help you understand it better. EXHIBIT 1-5 Cash on hand as well as in checking and savings accounts Amounts owed by customers The ski mountain owned by the company Study Tip The accounting equation and the financial statements are at the heart of this course. Memorize the accounting equation, and make sure you study this introduction to how the financial statements should look, how to read them, and what they say about a company. Owners' equity The owners' claims on the assets of an entity. Stockholders' equity The owners' equity in a corporation. Retained earnings The part of owners' equity that represents the income earned less dividends paid over the life of an entity. Balance sheet The financial statement that summarizes the assets, liabilities, and owners' equity at a specific point in time. Alternate term: Statement of financial position. Top of the World's Balance Sheet Amounts owed to suppliers Top of the World Balance Sheet June 30, 2008 (in thousands of dollars) Assets Cash Accounts receivable Land Lodge, lifts, and equipment Total assets The building, ski lifts, and ski equipment owned by the company $ 200 600 4,000 2,500 $7,300 Liabilities and Stockholders' Equity Accounts payable $ 700 Salaries and wages payable 400 Notes payable 3,000 Capital stock 2,000 Retained earnings 1,200 Total liabilities and stockholders' equity 15 $7,300 Income earned less dividends paid over life of corporation Amounts owed to employees Amounts owed to the bank Owners' contributions to the corporation 93740_01_ch01_p002-051.qxd 16 10/8/08 Chapter 1 Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 EXHIBIT 1-6 10:35 PM Page 16 Accounting as a Form of Communication The Relationship between the Accounting Equation and the Balance Sheet Assets Economic resources Examples: Cash Accounts receivable Land = Liabilities Creditors' claims to the assets Examples: Accounts payable Notes payable + Owners' Equity Owners' claims to the assets Examples: Capital stock Retained earnings Terminology Note: Exhibit 1-6 refers to Owners' Equity, while Exhibit 1-5 refers to Stockholders' Equity. Remember, both are correct! Owners' equity is the general term by which we refer to ownership. \"Stockholders' equity\" refers only to ownership of a corporation by shareholders. Because we emphasize corporations in this book, we will use the term Stockholders' equity. Two items should be noted in the heading of the statement. First, the company chose a date other than December 31, the calendar year-end, to finish its accounting or fiscal year. Although December 31 is the most common year-end, some companies choose a date other than this to conclude their year. Often this choice is based on when a company's peak selling season is over. For example, Gap Inc., ends its accounting year on the Saturday closest to January 31, after the busy holiday season. By June 30, Top of the World's ski season has ended and the company can devote its attention to preparing its financial statements. The second item to note in the heading of the statements is the last line: \"in thousands of dollars.\" This means, for example, that rather than cash being $200, the amount is actually 1,000 $200, or $200,000. Exhibit 1-6 summarizes the relationship between the accounting equation and the items that appear on a balance sheet. Income statement A statement that summarizes revenues and expenses. Alternate term: Statement of income. EXHIBIT 1-7 THE INCOME STATEMENT An income statement, or statement of income as it is sometimes called, summarizes the revenues and expenses of a company for a period of time. An income statement for Top of the World for its first year in business is shown in Exhibit 1-7. Unlike the Top of the World's Income Statement Top of the World Income Statement For the Year Ended June 30, 2008 (in thousands of dollars) Two types of revenue All costs of running a ski resort Revenues: Lift tickets Equipment rentals Total revenues Expenses: Salaries and wages Depreciation Water, gas, and electricity Insurance Interest Income taxes Total expenses Net income $5,800 2,200 $8,000 $2,000 100 1,500 1,100 300 1,000 6,000 $2,000 93740_01_ch01_p002-051.qxd 10/8/08 10:35 PM Page 17 Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 F inancial Statements: How Accountants Communicate balance sheet, an income statement is a flow statement. That is, it summarizes the flow of revenues and expenses for the year. The top portion of Exhibit 1-7 makes it clear that the ski company has two distinct types of revenues: those from selling lift tickets and those from renting ski equipment. For example, if you paid the company $50 for a one-day lift ticket and another $30 to rent your equipment for the day, each of those amounts would be included in Top of the World's revenues for the year. The expenses reported on the income statement represent all of the various costs necessary to run a ski resort. For example, a significant cost for such an operation is its payroll, as represented by salaries and wages on the income statement. Note that the amount reported for salaries and wages expense on the income statement is not the same amount that appeared as salaries and wages payable on the balance sheet. The expense of $2,000 on the income statement represents the total cost for the year, while the payable of $400 on the balance sheet is the amount owed to employees on June 30, 2008. We will have much more to say in later chapters about differences between balance sheet and income statement items. Finally, note that the excess of revenues over expenses, or net income, appears as the bottom line on the income statement. A company's net income is sometimes referred to as its profits or earnings. 17 Net income The excess of revenues over expenses. Alternate term: Profits or earnings. THE STATEMENT OF RETAINED EARNINGS As discussed earlier, Retained Earnings represents the accumulated earnings of a corporation less the amount paid in dividends to stockholders. Dividends are distributions of the net income or profits of a business to its stockholders. Not all businesses pay cash dividends. Among those companies that do pay dividends, the frequency with which they pay differs. For example, most companies that pay dividends do so four times a year. A statement of retained earnings explains the change in retained earnings during the period. The basic format for the statement is as follows: Beginning balance Add: Net income for the period Deduct: Dividends for the period Ending balance $xxx,xxx xxx,xxx xxx,xxx $xxx,xxx Dividends A distribution of the net income of a business to its owners. Statement of retained earnings The statement that summarizes the income earned and dividends paid over the life of a business. A statement of retained earnings for Top of the World is shown in Exhibit 1-8. Revenues minus expenses, or net income, is an increase in retained earnings; and dividends are a decrease in the balance. Why are dividends shown on a statement of retained earnings instead of on an income statement? Dividends are not an expense and thus are not a component of net income, as are expenses. Instead, they are a distribution of the income of the business to its stockholders. Recall that stockholders' equity consists of two parts: capital stock and retained earnings. In lieu of a separate statement of retained earnings, many corporations prepare a comprehensive statement to explain the changes both in the various capital stock accounts and in retained earnings during the period. Kellogg's, for example, presents the more comprehensive statement of shareholders' equity. EXHIBIT 1-8 Top of the World's Statement of Retained Earnings Top of the World Statement of Retained Earnings For the Year Ended June 30, 2008 (in thousands of dollars) Retained earnings, beginning of the year Add: Net income for the year Deduct: Dividends for the year Retained earnings, end of the year $ 0 2,000 (800) $1,200 93740_01_ch01_p002-051.qxd 18 10/8/08 Chapter 1 10:35 PM Page 18 Accounting as a Form of Communication T HE STATEMENT OF CASH FLOWS Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 Statement of cash flows The financial statement that summarizes a company's cash receipts and cash payments during the period from operating, investing, and financing activities. The statement of cash flows summarizes the cash flow effects of a company's operating, investing, and financing activities for the period. In essence, it shows the reader where a company got cash during the year and how it used that cash. (We will have more to say about this in Chapter 2.) A statement of cash flows for Top of the World is shown in Exhibit 1-9. Note the three categories of cash flow: operating, investing, and financing. The major source of cash to the company from its operations was the cash it collected from its customers. After deducting cash payments for operating activities, the ski company generated $2,600 from its operations. During the period, the company spent $6,600 on various assets. The last category shows that the issuance of a note generated $3,000 of cash and the issuance of stock produced another $2,000. Finally, the company paid dividends of $800. The net increase in cash from these three categories is $200; and since the company was new this year, this number is also its ending cash balance. RELATIONSHIPS AMONG THE FINANCIAL STATEMENTS Note the natural progression in the items from one statement to another. Normally, a company starts the period with balances in each of the items on its balance sheet. Because Top of the World is a new company, Exhibit 1-10 shows zero balances on July 1, 2007, the beginning of its first year in business. Next, the company operated during the year, the result was net income of $2,000 as shown on the income statement at the top of the exhibit. The net income naturally flows ! onto the statement of retained earnings. Again, because the ski company is new, its beginning retained earnings balance is zero. After the distribution of $800 to the owners in cash dividends $ , ending retained earnings amounts to $1,200. The ending retained earnings EXHIBIT 1-9 Top of the World's Statement of Cash Flows Top of the World Statement of Cash Flows For the Year Ended June 30, 2008 (in thousands of dollars) Cash flows from operating activities: Cash collected from customers Cash payments for: Salaries and wages Water, gas, and electricity Insurance Interest Income taxes Total cash payments Net cash provided by operating activities Cash flows from investing activities: Purchase of land Purchase of lodge, lifts, and equipment Net cash used by investing activities Cash flows from financing activities: Proceeds from issuance of long-term note Proceeds from issuance of capital stock Dividends declared and paid Net cash provided by financing activities Net increase in cash Cash at beginning of year Cash at end of year $ 7,400 $ 1,600 1,500 400 300 1,000 4,800 $ 2,600 $(4,000) (2,600) (6,600) $ 3,000 2,000 (800) 4,200 $ 200 0 $ 200 93740_01_ch01_p002-051.qxd 10/8/08 10:35 PM Page 19 F inancial Statements: How Accountants Communicate Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 EXHIBIT 1-10 Relationships among the Financial Statements Top of the World Income Statement For Year Ended June 30, 2008 Revenues Less: Expenses Net income $8,000 6,000 $2,000 Top of the World Statement of Retained Earnings For Year Ended June 30, 2008 $ 0 2,000 (800) $1,200 Beginning balance, retained earnings Add: Net income Deduct: Cash dividends Ending balance, retained earnings Top of the World Balance Sheets JUNE 30, 2008 Assets: Cash Accounts receivable Land Lodge, lifts, and equipment Total assets Liabilities Capital stock Retained earnings Total liabilities and stockholders e quity JULY 1, 2007 $ 200 600 4,000 2,500 $7,300 $0 0 0 0 $0 $4,100 2,000 1,200 $7,300 $0 0 0 $0 Top of the World Statement of Cash Flows For Year Ended June 30, 2008 Net cash provided by operating activities Net cash used by investing activities Net cash provided by financing activities Net increase in cash Cash at beginning of year Cash at end of year $ 2,600 (6,600) 4,200 $ 200 0 $ 200 number flows % onto the ending balance sheet along with the other June 30, 2008, balance sheet items. Finally, the net increase in cash at the bottom of the statement of cash flows equals Q the amount shown on the June 30, 2008, balance sheet. LOOKING AT FINANCIAL STATEMENTS FOR A REAL COMPANY: KELLOGG'S You would certainly expect the financial statements of companies in the real world to be more complex than those for a hypothetical company such as Top of the World. Still, even this early in your study of accounting, there are certain fundamental points about all financial statements, real-world or otherwise, that you can appreciate. 19 93740_01_ch01_p002-051.qxd 20 10/8/08 Chapter 1 Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 Real World Practice 1-1 Reading Kellogg's Balance Sheet State Kellogg's financial position on December 30, 2006, in terms of the accounting equation. What amount do Kellogg's customers owe on December 30, 2006? What amount does Kellogg's owe its suppliers on this same date? EXHIBIT 1-11 10:35 PM Page 20 Accounting as a Form of Communication KELLOGG'S BALANCE SHEET Balance sheets for Kellogg's at the end of two recent years are shown in Exhibit 1-11. For comparative purposes, the company reports its financial position not only at the end of the most recent year, December 30, 2006, but also on December 31, 2005. Also note the statement across from the headings for the two years that the amounts are in millions of dollars. For example, this means that Kellogg's had $10,714 1,000,000, or $10,714,000,000, of total assets at the end of 2006. TOTAL ASSETS: $10,714 1,000,000 10,714,000,000 Approximately 10.7 billion dollars! A quick comparison of Kellogg's assets with those of Top of the World reveals one significant difference. Because the ski company is a service company, it does not have an inventory account on its balance sheet. Conversely, \"Inventories\" of $823.9 million at the end of 2006 is a significant asset for Kellogg's. This account includes the various raw materials and products in various stages of production that have not yet been sold to customers. Various types of liabilities are reported on Kellogg's balance sheets, and we will return to look more closely at many of these in later chapters. For now, it is worth Kellogg's Balance Sheet Consolidated Balance Sheet (millions, except share data) Current assets Cash and cash equivalents Accounts receivable, net Inventories Other current assets Total current assets Property, net Other assets 2006 A Materials and goods in various stages of production account for over $800 million of the assets. $ 410.6 944.8 823.9 247.7 $ 2,427.0 2005 $ 219.1 879.1 717.0 381.3 $ 2,196.5 2,815.6 5,471.4 2,648.4 5,729.6 $10,714.0 $10,574.5 $ 723.3 1,268.0 910.4 1,118.5 $ 4,020.2 $ 83.6 1,111.1 883.3 1,084.8 $ 3,162.8 Long-term debt Other liabilities 3,053.0 1,571.8 3,702.6 1,425.4 Shareholders' equity SE Common stock, $.25 par value, 1,000,000,000 shares authorized Issued: 418,515,339 shares in 2006 and 418,451,198 shares in 2005 Capital in excess of par value Creditors' claims and Retained earnings shareholders' equity is the Treasury stock at cost: same as total assets. 20,817,930 shares in 2006 and 13,121,446 shares in 2005 Accumulated other comprehensive income (loss) 104.6 292.3 3,630.4 104.6 58.9 3,266.1 (912.1) (1,046.2) (569.8) (576.1) Total assets Current liabilities Current maturities of long-term debt Notes payable Accounts payable Other current liabilities Total current liabilities Total assets of almost $11 billion L Creditors' claims are about $8.6 billion. Total shareholders' equity $ 2,069.0 $ 2,283.7 Total liabilities and shareholders' equity $10,714.0 $10,574.5 93740_01_ch01_p002-051.qxd 10/8/08 10:35 PM Page 21 Financial Statements: How Accountants Communicate Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 noting that total liabilities amount to $8,645 million at the end of 2006. Total shareholders' equity amounts to $2,069 million, of which the balance in retained earnings is $3,630.4 million. KELLOGG'S INCOME STATEMENT Comparative income statements for three recent years are shown in Exhibit 1-12. As was the case for the balance sheet, you are not expected at this point to understand fully all of the complexities involved on the income statement of a real company. However, note the two largest items on the income statement: Net sales and Cost of goods sold. For now, it is sufficient for you to understand that the former is the revenue Kellogg's earned from selling its various products and the latter is the cost of these products. Net sales for the most recent year amounted to nearly $11 billion, and Kellogg's cost to produce the goods sold was just over $6 billion. Net income for the year amounted to just over $1 billion after selling, general, and administrative expense; interest expense; income taxes; and two other minor items are taken into account. 21 Real World Practice 1-2 Reading Kellogg's Income Statement Compute the percentage increase in Net sales and Cost of goods sold from 2005 to 2006. Which of these two items on the income statement increased by the larger percentage? What does this mean to the management of Kellogg's? P O D R E V I E W 1.5 LO5 Explain the purpose of each of the financial statements and the relationships among them and prepare a set of simple statements. Four major financial statements are covered in this chapter: balance sheet, income statement, statement of retained earnings, and statement of cash flows. The balance sheet is a snapshot of a company's financial position at the end of the period. It reflects the assets, liabilities, and stockholders' equity accounts. The income statement summarizes the financial activity for a period of time. Items of revenues, expenses, gains, and losses are reflected in the income statement. Ultimately, all net income (loss) and dividends are reflected in retained earnings on the balance sheet. The statement of retained earnings links the income statement to the balance sheet by showing how net income (loss) and dividends affect the retained earnings account. The statement of cash flows summarizes the cash flow effects of a company's operating, investing and financing activities. QUESTIONS 1 . Which of the following financial statements summarizes the financial position of a company at a point in time? a. b. c. d. income statement balance sheet statement of retained earnings statement of cash flows 2 . On a statement of retained earnings, how are net income and dividends treated? a. Net income is added and dividends are deducted. b. Both net income and dividends are added. c. Both net income and dividends are deducted. d. Net income is deducted, and dividends are added. 3 . Revenues are reported on which of the following financial statements? a. balance sheet only b. income statement only c. both the balance sheet and the income statement d. neither the balance sheet nor the income statement 93740_01_ch01_p002-051.qxd 22 10/8/08 Chapter 1 Gary Porter, Curt Norton, Using Financial Accounting Information 6e: The Alternative to Debits and Credits, Mason, OH: Cengage South-Western, 2010 EXHIBIT 1-12 10:35 PM Page 22 Accounting as a Form of Communication Kellogg's Income Statement Consolidated Statement of Earnings (millions, except per share data) 2006 Net sales Cost of goods sold Selling, general, and administrative expense Operating profit Interest expense